1. 1 Chapter Three A PowerPoint  Tutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw Mannig J. Simidian ® CHAPTER THREE National Income: Where It Comes From and Where It Goes

2. 2 Chapter Three Copyright 1997 Dead Economists Society A quite simple but powerful analytical model built around buyers and sellers pursuing their own self-interest (within rules set by government). It’s emphasis is on the consequences of competition and flexible wages/prices for total employment and real output. Its roots go back to 1776 in Adam Smith’s Wealth of Nations. The Wealth of Nations suggested that the economy was controlled by the “invisible hand” whereby the market system, instead of government would be the best mechanism for a healthy economy.

3. 3 Chapter Three The heart of the market system lies in the “market clearing” process and the consequences of individuals pursuing self-interest. In this module, we will develop a basic classical model to explain various economic interactions. Proceed to the next slide to the “CLASSICAL FACTORY” to learn how to construct the classical model.

4. 4 Chapter Three P P Q Q P* Q* S S D D The place where classical model mechanics are made easy! The place where classical model mechanics are made easy! Welcome to...

5. 5 Chapter Three We begin with firms and see what determines their level of production (and thus, the level of national income). Then, we examine how the markets for the factors of production distribute this income to households. Next, we consider how much of this income households consume and how much they save. We will also discuss the demand arising from investment and government purchases. Finally, we discuss how the demand and supply for goods and services are brought into balance.

6. 6 Chapter Three An economy’s output of goods and services (GDP) depends on: (1)quantity of inputs (2)ability to turn inputs into output Let’s go over both now.

7. 7 Chapter Three LK The factors of production are the inputs used to produce goods and services. The two most important factors of production are capital and labor. In this module, we will take these factors as given (hence the overbar depicting that these values are fixed). K (capital) = K L (labor) = L In this module, we’ll also assume that all resources are fully utilized, meaning no resources are wasted.

8. 8 Chapter Three The available production technology determines how much output is produced from given amounts of capital (K) and labor (L). The production function represents the transformation of inputs into outputs. A key assumption is that the production function has constant returns to scale, meaning that if we increase inputs by z, output will also increase by z. We write the production function as: Y = F ( K, L ) Income is some function of our given inputs our given inputs

9. 9 Chapter Three We can now see that the factors of production and the production function together determine the quantity of goods and services supplied, which in turn equals the economy’s output. So, Y = F ( K, L ) = Y In this section, because we assume that capital and labor are fixed, we can also conclude that Y (output) is fixed as well.

10. 10 Chapter Three The distribution of national income is determined by factor prices. Factor prices are the amounts paid to the factors of production– the wages workers earn and the rent the owners of capital collect. Because we have assumed a fixed amount of capital and labor, the factor supply curve is a vertical line. The next slide will illustrate. Recall that the total output of an economy equals total income. Because the factors of production and the production function together determine the total output of goods and services, they also determine national income.

11. 11 Chapter Three The price paid to any factor of production depends on the supply and demand for that factor’s services. Because we have assumed that the supply is fixed, the supply curve is vertical. The demand curve is downward sloping. The intersection of supply and demand determines the equilibrium factor price.FactorPrice (Wage or RentalRate) Quantity of Factor Factor demand Factor supply Equilibrium factor price

12. 12 Chapter Three To make a product, the firm needs two factors of production, capital and labor. Let’s represent the firm’s technology by the usual production function: Y = F (K, L) The firm sells its output at price P, hires workers at a wage W, and rents capital at a rate R.

13. 13 Chapter Three The goal of the firm is to maximize profit. Profit is revenue minus cost. Revenue equals P × Y. Costs include both labor and capital costs. Labor costs equal W × L, the wage multiplied by the amount of labor L. Capital costs equal R × K, the rental price of capital R times the amount of capital K. Profit = Revenue - Labor Costs - Capital Costs = PY-WL -RK Then, to see how profit depends on the factors of production, we use production function Y = F (K,L) to substitute for Y to obtain: Profit = P × F (K,L) - WL - RK This equation shows that profit depends on P, W, R, L, and K. The competitive firm takes the product price and factor prices as given and chooses the amounts of labor and capital that maximize profit.

14. 14 Chapter Three We know that the firm will hire labor and rent capital in the quantities that maximize profit. But, what are those maximizing quantities? To answer this, we must consider the quantity of labor and then the quantity of capital.

15. 15 Chapter Three The marginal product of labor (MPL) is the extra amount of output the firm gets from one extra unit of labor, holding the amount of capital fixed and is expressed using the production function: MPL = F(K,L + 1) - F(K,L). Most production functions have the property of diminishing marginal product: holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases. F (K, L) Y L 1 MPL 1 The MPL is the change in output when the labor input is increased by 1 unit. As the amount of labor increases, the production function becomes flatter indicating diminishing marginal product.

16. 16 Chapter Three When the competitive, profit-maximizing firm is deciding whether to hire an additional unit of labor, it considers how that decision would affect profits. It therefore compares the extra revenue from the increased production that results from the added labor to the extra cost of higher spending on wages. The increase in revenue from an additional unit of labor depends on two variables: the marginal product of labor, and the price of the output. Because an extra unit of labor produces MPL units of output and each unit of output sells for P dollars, the extra revenue is P × MPL. The extra cost of hiring one more unit of labor is the wage W. Thus, the change in profit from hiring an additional unit of labor is  Profit =  Revenue -  Cost = (P × MPL) - W

17. 17 Chapter Three Thus, the firm’s demand for labor is determined by P × MPL = W, or another way to express this is MPL = W/P, where W/P is the real wage-- the payment to labor measured in units of output rather than in dollars. To maximize profit, the firm hires up to the point where the extra revenue equals the real wage. The MPL depends on the amount of labor. The MPL curve slopes downward because the MPL declines as L increases. This schedule is also the firm’s labor demand curve. Units of output Units of labor, L MPL, labor demand Quantity of labor demanded Real wage

18. 18 Chapter Three The firm decides how much capital to rent in the same way it decides how much labor to hire. The MPK is the amount of extra output the firm gets from an extra unit of capital, holding the amount of labor constant: MPK = F(K + 1,L) - F(K,L). Thus, the marginal product of capital is the difference between the amount of output produced with K+1 units of capital and that produced with K units of capital. Like labor, capital is subject to diminishing marginal product. The increase in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machine’s rental price:  Profit =  Revenue -  Cost = (P × MPK) - R To maximize profit, the firm continues to rent more capital until the MPK falls to equal the real rental price, MPK = R/P. The real rental price of capital is the rental price measured in units of goods rather than in dollars. The firm demands each factor of production until that factor’s marginal product falls to equal its real factor price.

19. 19 Chapter Three The income that remains after the firms have paid the factors of production is the economic profit of the owners of the firms. Real economic profit is: Economic Profit = Y - (MPL × L) - (MPK × K) or to rearrange: Y = (MPL × L) - (MPK × K) + Economic Profit. Total income is divided among the returns to labor, the returns to capital, and economic profit. How large is economic profit? If the production function has the property of constant returns to scale, then economic profit is zero. This conclusion follows from Euler’s Theorem, which states that if the production function has constant returns to scale, then F(K,L) = (MPK × K) - (MPL × L) If each factor of production is paid its marginal product, then the sum of these factor payments equals total output. In other words, constant returns to scale, profit maximization,and competition together imply that economic profit is zero.

20. 20 Chapter Three Y = C + I + G + NX Total demand for domestic output (GDP) Total demand for domestic output (GDP) Recall from Chapter 2, we identified the four components of GDP: We are going to assume a closed economy, therefore eliminating the last term net exports, NX. So, the three components of GDP are Consumption (C), Investment (I) and Government purchases (G). Let’s see how GDP is allocated among these three uses. Consumption spending by households Consumption spending by households is composed of is composed of Government purchases of goods and services Government purchases of goods and services Investment spending by businesses and households Investment spending by businesses and households Net exports or net foreign demand Net exports or net foreign demand

21. 21 Chapter Three C = C(Y- T) consumption spending by households dependson disposableincome C Y-T The slope of the consumption function is the MPC. C = C( Y-T)

22. 22 Chapter Three The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income (Y-T) increases by one dollar. To understand the MPC consider a shopping scenario. A person who loves to shop probably has a large MPC, let’s say (.99). This means that for every extra dollar he or she earns after tax deductions, he or she spends $.99 of it. The MPC measures the sensitivity of the change in one variable (C) with respect to a change in the other variable (Y-T). The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income (Y-T) increases by one dollar. To understand the MPC consider a shopping scenario. A person who loves to shop probably has a large MPC, let’s say (.99). This means that for every extra dollar he or she earns after tax deductions, he or she spends $.99 of it. The MPC measures the sensitivity of the change in one variable (C) with respect to a change in the other variable (Y-T).

23. 23 Chapter Three I = I(r) Investment spending depends on real interest rate The quantity of investment depends on the real interest rate, which measures the cost of the funds used to finance investment. When studying the role of interest rates in the economy, economists distinguish between the nominal interest rate and the real interest rate, which is especially relevant when the overall level of prices is changing. The nominal interest rate is the interest rate as usually reported; it is the rate of interest that investors pay to borrow money. The real interest rate is the nominal interest rate corrected for the effects of inflation.

24. 24 Chapter Three Real interest rate, r Quantity of investment, I Investment function, I(r) The investment function relates the quantity of investment I to the real interest rate r. Investment depends on the real interest rate because the interest rate is the cost of borrowing. The investment function slopes downward; when the interest rate rises, fewer investment projects are profitable.

25. 25 Chapter Three We take the level of government spending and taxes as given. If government purchases equal taxes minus transfers, then G = T, and the government has a balanced budget. If G > T, then the government is running a budget deficit. If G < T, then the government is running a budget surplus. G = G T = T

26. 26 Chapter Three The following equations summarize the discussion of the demand for goods and services: 1) Y = C + I + GDemand for Economy’s Output 2) C = C(Y-T)Consumption Function 3) I = I(r)Real Investment Function 4) G = GGovernment Purchases 5) T = TTaxes 1) Y = C + I + GDemand for Economy’s Output 2) C = C(Y-T)Consumption Function 3) I = I(r)Real Investment Function 4) G = GGovernment Purchases 5) T = TTaxes The demand for the economy’s output comes from consumption, investment, and government purchases. Consumption depends on disposable income, investment depends on the real interest rate; government purchases and taxes are the exogenous variables set by fiscal policy makers.

27. 27 Chapter Three To this analysis, let’s add what we’ve learned about the supply of goods and services earlier in the module. There we saw that the factors of production and the production function determine the quantity of output supplied to the economy: Y = F (K,L) = Y Now, let’s combine these equations describing supply and demand for output Y. Substituting all of our equations into the national income accounts identity, we obtain: Y = C(Y-T) + I(r) + G and then, setting supply equal to demand, we obtain an equilibrium condition: Y = C(Y-T) + I(r) + G This equation states that the supply of output equals its demand, which is the sum of consumption, investment, and government purchases.

28. 28 Chapter Three Y = C(Y-T) + I(r) + G Notice that the interest rate r is the only variable not already determined in the last equation. This is because the interest rate still has a key role to play: it must adjust to ensure that the demand for goods equals the supply. The greater the interest rate, the lower the level of investment. and thus the lower the demand for goods and services, C + I + G. If the interest rate is too high, investment is too low, and the demand for output falls short of supply. If the interest rate is too low, investment is too high, and the demand exceeds supply. At the equilibrium interest rate, the demand for goods and services equals the supply. Let’s now examine how financial markets fit into the story.

29. 29 Chapter Three First, rewrite the national income accounts identity as Y - C - G = I. The term Y-C-G is the output that remains after the demands of consumers and the government have been satisfied; it is called national saving or simply, saving (S). In this form, the national income accounts identity shows that saving equals investment. To understand this better, let’s split national saving into two parts-- one examining the saving of the private sector and the other representing the saving of the government. (Y-T-C) + (T-G) = I The term (Y-T-C) is disposable income minus consumption, which is private saving. The term (T-G) is government revenue minus government spending, which is public saving. National saving is the sum of private and public saving.

30. 30 Chapter Three To see how the interest rate brings financial markets into equilibrium, substitute the consumption function and the investment function into the national income accounts identity: Y - C (Y-T) - G = I(r) Next, note that G and T are fixed by policy and Y is fixed by the factors of production and the production function:Y - C (Y-T) - G = I(r) S = I(r) Investment, Saving, I, S Desired Investment, I(r) Real interest rate, r Saving, S S Equilibrium interest rate The vertical line represents saving-- the supply of loanable funds. The downward-sloping line represents investment-- the demand for loanable funds. The intersection determines the equilibrium interest rate.

31. 31 Chapter Three An Increase in Government Purchases: If we increase government purchases by an amount  G, the immediate impact is to increase the demand for goods and services by  G. But since total output is fixed by the factors of production, the increase in government purchases must be met by a decrease in some other category of demand. Because disposable Y-T is unchanged, consumption is unchanged. The increase in government purchases must be met by an equal decrease in investment. To induce investment to fall, the interest rate must rise. Hence, the rise in government purchases causes the interest rate to increase and investment to decrease. Thus, government purchases are said to crowd out investment. A Decrease in Taxes: The immediate impact of a tax cut is to raise disposable income and thus to raise consumption. Disposable income rises by  T, and consumption rises by an amount equal to  T times the MPC. The higher the MPC, the greater the impact of the tax cut on consumption. Like an increase in government purchases, tax cuts crowd out investment and raises the interest rate.

32. 32 Chapter Three S'S' Investment, Saving, I, S Desired Investment, I(r) Real interest rate, r Saving, S S A reduction in saving, possibly the result of a change in fiscal policy, shifts the saving schedule to the left. The new equilibrium is the point at which the new saving schedule crosses the investment schedule. A reduction in saving lowers the amount of investment and raises the interest rate. A reduction in saving, possibly the result of a change in fiscal policy, shifts the saving schedule to the left. The new equilibrium is the point at which the new saving schedule crosses the investment schedule. A reduction in saving lowers the amount of investment and raises the interest rate. Fiscal policy actions are said to crowd out investment.

33. 33 Chapter Three An increase in the demand for investment goods shifts the investment schedule to the right. At any given interest rate, the amount of investment is greater. The equilibrium moves from A to B. Because the amount of saving is fixed, the increase in investment demand raises the interest rate while leaving the equilibrium amount of investment unchanged. Now let’s see what happens to the interest rate and saving when saving depends on the interest rate (upward-sloping saving (S) curve). Investment, Saving, I, S I1I1 Real interest rate, r Saving, S S I2I2 A B

34. 34 Chapter Three When saving is positively related to the interest rate, as shown by the upward-sloping S(r) curve, a rightward shift in the investment schedule I(r), increases the interest rate and the amount of investment. The higher interest rate induces people to increase saving, which in turn allows investment to increase. Investment, Saving, I, S I1I1 Real interest rate, r S(r) I2I2 A B

35. 35 Chapter Three Factors of production Production function Constant returns to scale Factor prices Competition Marginal product of labor (MPL) Diminishing marginal product Real wage Marginal product of capital (MPK) Real rental price of capital Economic profit vs. accounting profit Disposable income Consumption function Marginal propensity to consume Nominal interest rate Real interest rate National saving (saving) Private saving Public saving Loanable funds Crowding out